Financial Statement Risk analysis Chapter 9

Introduction to Financial statements Used to make business decisions Provide information about a company’s financial activities Four Key Financial Statements: 1. Balance Sheet 2. Income Statement 3. Statement of Changes in Shareholders’ Equity 4. Statement of Cash Flows

Balance sheet Summarizes a company’s assets, liabilities, and shareholders’ equity at a specific point in time (“snapshot”) Based on GAAP Accounting equation Assets – Liabilities = Equity

Balance sheet Assets Liabilities Shareholders’ Equity Current Assets Cash Marketable Securities Accounts/Notes Receivables Prepaid Expenses Inventories Fixed Assets Land Buildings Equipment Intangibles such as goodwill, patents, copyrights, and trademarks Liabilities Current Liabilities Accounts/Wages/Taxes Payable Short-term Debt Noncurrent Liabilities Long-term Debt Shareholders’ Equity Total Shareholders’ Equity (Owners’ Equity) *p 9.7 for a sample balance sheet

Income statement Measures a company’s performance of profitability over a specific period of time Based on GAAP Reports a company’s profit gain or loss with its revenue

Components of the income statement Revenue: income that a company receives from normal business activities such as from the sale of goods and services to customers Expenses: outflow of money to pay for a good or service Cost of goods sold Gross Profit: sales minus cost of goods sold Operating Income: amount of profit from a business’s operations after taking out operating expenses (EBIT) Net Income: a company’s earnings after subtracting all expenses “bottom line”

Statement of changes in shareholders’ equity Shows increases or decreases in the equity of the business from the beginning to the end of the period 4 major components of shareholders’ equity: 1. Paid-Capital 2. Retained Earnings 3. Accumulated Other Comprehensive Income 4. Treasury Stock

components of shareholders’ equity Paid-In Capital Capital contributed to a business by owners through the purchase of stock from the business Retained Earnings Portion of profits kept by the company to be reinvested in the business for future needs Accumulated Other Comprehensive Income Measures gains and losses of the company that have not been realized yet Includes changes in pension costs, foreign currency investments, and appreciation/depreciation of investments Treasury Stock The buying back of a company’s own stock *p 9.15 for a sample statement of changes in stockholders’ equity

Statement of cash flows Purpose is to provide information about a business’s cash receipts and cash payments during a period of time Operating Activities reflect the transactions of operating cash inflows and outflows Investing Activities show the cash inflows and outflows in the purchase or sale of assets, the receiving or selling of marketable securities, and payment of loans Financing Activities include paying of dividends, issue or repurchase of the company’s stock, bonds, and other debt *p 9.16 for a sample statement of cash flows

Supplemental sources of financial information Notes to financial statements SEC filings Annual reports

Notes to financial statements Contain details to better explain the data within the financial statements Summary of loss contingencies is closely related to risk management and issues of insurance Examples: Litigations Product warranty and defect obligations Possibility of damage or loss of property due to hazards

SEC filings Financial statements and documents submitted to the Securities and Exchange Commission Most frequently accessed reports include the Form 10-K, Form 10-Q, and Form 8-K

Sec filings Form 10-K : annually filed report that is similar to the company’s own annual report, only much more in detail Form 10-Q : shortened version of the 10-K; quarterly filed report that provides a view of the company’s condition financially for the prior three months Form 8-K : a current report that is filed to announce a major event to the shareholders

Company annual reports The formal documents reporting the company’s performance for the year Required sections of the annual report includes the following: Financial statements and notes Auditor’s report Report of management Management’s discussion and analysis of operations and financial position Other beneficial financial data Companies may provide additional information that is not required as well

Reports The Report of Management is an internal control report acknowledging management’s responsibility to the quality of accounting principles, employee communications, and other internal auditing procedures. Management’s Discussion and Analysis of Results (MD&A) gives a narrative explanation through management’s perception of how the company is performing, its current position, and its future outlook.

Sarbanes-Oxley act of 2002 Federal law put in place to protect investors, enhance internal controls, and increase penalties for fraudulent financial activity against corporate directors Increases financial reporting transparency

Income statement trend analysis Used to see how a business has performed over two or more periods of time Usually applied to the income statement Calculate the percentage of change from one year to the next Annual Percentage Change Trend analysis can be helpful in predicting the future prospects of a business

Liquidity risk Ratio Analysis Liquidity: how quickly an asset can be converted to cash with no loss of value Can be measured using: Working Capital = Current Assets – Current Liabilities Current Ratio = Current Assets / Current Liabilities Acid-Test Ratio = (Current Assets – Inventory) / Current Liabilities Also known as the Quick Ratio

Capital structure The way a corporation finances its assets through a mixture of long- term debt and equity Equity Common stockholders versus Preferred stockholders Debt Short-term liabilities: due within one year or less Long-term liabilities: due in more than one year

Financial leverage The usage of debt to increase returns to shareholders Financial leverage analysis compares the possible earnings per share (EPS) under different levels of debt and equity Return on Equity (ROE) = Net Income / Equity

Limitations of financial leverage Additional cost of increased debt Cash flow availability and flexibility economized Increased risk of default and possibility of bankruptcy

Operating leverage Components of a company’s cost structure: Fixed Costs : costs that basically remains unchanged regardless of changes in production level or cost of goods and services Examples include rent and interest Variable Costs : costs that vary according to production output Examples include wages, utilities, and raw materials used Changing these percentages influences operating leverage Advantages and disadvantages for both fixed and variable costs Vs. Financial leverage which is the use of Debt